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Are You Prepared for a Market Correction?

Volatility is coming – get ready for it.

Don't let the August market doldrums lull you into complacency. The market will very likely get much more volatile before the end of the year. If you're not prepared, a spike in the level of volatility could lead you to take rash action, which rarely produces the best outcomes. Worse still, you could miss out on the opportunities that price action creates. Here are some ideas to prevent that from happening.

Volatility is coming -- it's in the numbersFirst, why do I think that higher volatility is on the way? For evidence of that, one need only look at the prices of VIX futures expiring in September and beyond. The VIX index is a measure of the market's expectations for future volatility in the S&P 500, based on the stock index's option prices. High VIX values typically accompany market declines, with investors paying up for puts to hedge their stock holdings; thus, the VIX's nickname: Wall Street's "fear gauge."

On Friday, the index closed at 21.74 – the lowest value since the beginning of May, when the market started experiencing palpitations. By contrast, the October VIX futures contract closed at 29.15. For context, the VIX's average closing price during the months of May and June was 30.9 – you'll remember that was a challenging period for stocks.

What you shouldn't doDon't go out and short the SPDR S&P 500 ETF(NYSE: SPY) on this basis. As far as I know, the VIX isn't reliable enough to enable you to time the market (what indicator is?). Furthermore, it's certainly conceivable that the market is overestimating the level of future volatility. Although I think this unlikely, as PIMCO Chief Investment Officer Mohamed El-Erian wrote last week: "With declining confidence in a reliable set of investing rules, markets have become more susceptible to overreactions to daily news and are, therefore, more volatile."

Nevertheless, if you anticipate higher volatility, there are other ways to profit from market declines if you are looking at the right set of stocks beforehand. For example, if market prices do begin to swing wildly, we should expect high-beta stocks to be on the sharp end of that trend (beta is a standard measure of how volatile a stock has been relative to the overall market).

The best stock in a 'pariah' sectorThe 15th-highest beta stock in the S&P 500, Masco(NYSE: MAS), is more than twice as volatile as the S&P 500 (beta: 2.26). One of the world's largest manufacturers of branded products for home improvement and new home construction, it's one of the best names in an industry that has been run out of town by investors due to its dependency on the housing market. Although the shares currently change hands at 17 times estimated earnings for 2011, net income has significantly understated cash earnings over the past several years. If the market were to slip on a banana peel, it could provide a very attractive entry point to own Masco.

'High-beta' isn't the only strategyFocusing in on high-beta stocks may be overthinking things. Megacap stocks tend to be relatively less volatile than the broad market, but you can't throw a dart at the list of Dow components without hitting a stock that is already attractively priced (well a couple of darts, at any rate). Take a look at these four:

High-quality: A good choice in the current environmentAny one of these stocks is a certificate of ownership for an armor-plated franchise, none of which carry a lot of debt. Both of which are attractive characteristics at a time when the economy is vacillating on the edge of deflation. Alternatively, if you aren't interested in selecting specific stocks, you could certainly do worse than to own the index, through the SPDR Dow Jones Industrial Average ETF(NYSE: DIA).

Being ready for the next correctionIn many ways, the current period marks the mirror image of the last stage of the technology bubble when high-quality, large-cap stocks traded at staggering multiples and were one of the most expensive segments of the market. Today, the same stocks are rather cheaper than the broad market – a rare phenomenon.

If your portfolio is heavy with low-quality, highly leveraged companies, you should be aware that those stocks are particularly vulnerable to a potential autumn market correction. Meanwhile, such a correction would provide an opportunity to buy shares in blue-chip, "franchise" stocks at even better prices than the ones on offer today. That's certainly a prospect worth being prepared for.

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